A year ago, investors began weighing the implications of a possible default by China’s biggest property developer, Evergrande. The company had $300 billion in outstanding debt and China’s property market weakened following measures taken by the Chinese government in 2021 to curb soaring property prices.
Around this time, Ed Yardeni raised the specter that an Evergrande collapse could turn into China’s version of a “The Lehman Moment”. But most economists downplayed the likelihood of a global contagion and U.S. investors ignored it.
My assessment then was that the fallout from an Evergrande default would take longer to occur than the US housing crisis of 2007-2008. The main consideration was that bank loans to Chinese property developers are not negotiable instruments and the arrangements are subject to complex negotiations and regulatory oversight that can take years to settle. Evergrande, for example, recently missed its own deadline to restructure its business by July 31.
At the same time, I argued that investors should pay attention to what is happening, as China’s real estate market is a dominant sector and an integral part of China’s remarkable economic transformation. Real estate accounts for more than two-thirds of household assets compared to around a quarter for American households. Therefore, a dismantling of this sector could rival what happened in the United States during the real estate crisis.
Last year, spillovers to other sectors were limited as aggregate demand held up as China weathered the COVID-19 pandemic reasonably well. A Reuters survey of 10 analysts and economists showed they were still optimistic about property values and expected them to rise 5% this year. Instead, prices have fallen for 11 consecutive months, and they appear to be heading for further lows.
One of the reasons for weakening property prices is the Chinese government’s zero-tolerance policy towards COVID, in which parts of the country have been shut down in response to outbreaks. Economic activity was barely positive in the second quarter of this year, and investment firms, including Goldman Sachs and Nomuracut their forecast for economic growth this year to 3% – well below the government’s target of 5.5% which it says is no longer achievable.
Meanwhile, the problems are spreading because the apartment buying process in China requires buyers to make substantial down payments on complexes under construction. The collapse of the economy has caused developers’ finances to deteriorate to the point that they are unable to carry out many projects. Some buyers, in turn, have responded by withholding payments on their mortgages, and protests against property developers are growing.
As a result, Chinese banks are under pressure on two fronts. The asset side of their balance sheets is under pressure from bad debts from developers and apartment buyers. (Note: property-related loans account for about 30% of all bank loans.) At the same time, the liabilities of some smaller banks have been hit by shuns their depositors.
To support the sector, the Chinese authorities have lowered interest rates to make mortgage payments more affordable. They also try to support real estate developers by offering financial assistance. The Council of State recently adopted a project to create a fund worth up to 300 billion yuan ($44 billion) to support several real estate groups. But these measures seem insufficient to stem the problem.
The outcome ultimately depends on how Chinese households react if property values continue to fall. The main risk is that China faces a loss in household confidence at a time when business confidence is fragile due to government crackdowns on tech and other private companies. This combination could lead to a recession in growth, or even an outright recession.
Professor Robert Z. Aliber, co-author of Charles Kindleberger’s classic, “Manias, Panics and Crashes”, goes much further. He sees the bursting of China’s housing bubble as marking the end of the country’s economic miracle of the past four decades: a declining population and forty or sixty million vacant, overpriced apartments.
This raises the question of whether a slump in China’s property market could spread to other parts of the world. The main reason to believe that it will not spread is that the involvement of foreign investors in the Chinese property market and financial system is weak. By comparison, European investors were heavily involved in mortgage-backed securities issued by US institutions during the housing boom.
That said, given the importance of the Chinese economy in the global economy and international trade, a weakening would affect China’s major trading partners in Asia, Europe and North America. According to the calculations of JPMorgan Asset Management, China’s strong performance in the decade following the 2008-2009 global financial crisis accounted for about 30% of global economic growth. Therefore, if China’s economic engine came to a halt, it would likely spill over into global markets.
Nicholas Sargen, Ph.D., is an international economist and global fund manager who is a consultant to Fort Washington Investment Advisors and is affiliated with the Darden School of Business at the University of Virginia. He is the author of three books, including “Global Shocks: An Investing Guide for Turbulent Markets. »